Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Friday, September 21, 2012

Kocherlakota: Some Iffy Ideas

Here is another post-QE3-announcement speech by a Fed President. This time it's Narayana Kocherlakota, Minneapolis Fed president, who is focused on how the Fed might provide clearer messages with forward guidance. While I liked what Jeff Lacker had to say - I thought he provided a good case for no change in policy - I'm not much excited about what Kocherlakota has to say.

Kocherlakota makes very clear what he's recommending. Indeed, it's written out twice in the speech, in bold:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

As he points out at the end of the speech, this is in the spirit of policies that Charles Evans (Chicago Fed) has supported.

Elaborating on this, Kocherlakota's key points are:

1. This does not violate the Fed's commitment to 2% inflation. Some people - Woodford in particular - have recommended that the Fed tolerate higher inflation immediately after "liftoff" occurs (liftoff is the time at which the Fed commences tightening).

2. If liftoff occurs when the unemployment rate is too high, this will prolong the period of high unemployment.

3. Kocherlakota is confident that the Fed is not going to be faced with the prospect of tightening before the unemployment rate reaches 5.5%. He trusts the Fed's inflation forecasts and thinks the inflation rate will remain at 2% - plus or minus 1/4%.

At this point, I think people have started to take forward guidance far too seriously. You can see that in Woodford's Jackson Hole paper. These things may be fun to think about, but ultimately I think the effects are second-order. The Fed, in trying to make commitments, has probably created more confusion, with the result that tweaking the forward guidance carries no information at all.

Possibly Kocherlakota thinks that his proposed policy rule is simple enough that everyone can understand it, and the message will be crystal clear. Not to me. Why the unemployment rate? Why 5.5%? Why a tolerance band of plus or minus 1/4% around the inflation target? We're not given the answers to those questions, and I can only think of reasons why these might represent bad choices. Does the fraction of the labor force actively seeking work accurately capture the inefficiency in the economy that the Fed can correct? The "efficient" unemployment rate fluctuates for all kinds of reasons. By 2015, is Kocherlakota going to feel the same way about 5.5% he does now?

What's missing in Kocherlakota's talk? We're never really given a story about what determines the inflation rate. The closest we get is this:

I noted earlier that the FOMC’s current projections for the long-run unemployment rate are well below 8.1 percent. These projections suggest that there will be little upward pressure on inflation until the recovery is sufficiently robust that the unemployment rate has fallen back to a level that is more consistent with historical norms. I see an unemployment threshold of 5.5 percent as being readily rationalized under this perspective, although slightly higher or slightly lower thresholds should not materially affect the impact of this plan.

Thus, in Kocherlakota's mind, there seems to exist a Phillips curve theory of inflation, which is more than a little troubling. And why would anyone be thinking about "historical norms" at a time when nothing is normal? The financial system is holding a very large stock of reserves, those reserves are bearing interest, and the policy rate is close to zero. Nothing normal about that - it's totally different from what existed pre-financial crisis. Central bankers should be thinking about why that could mean something different about how we should think about future unemployment and inflation.

In an earlier post I talked about how Kocherlakota in particular has bent over backwards to speak the New Keynesian language of some of his other colleagues on the FOMC. Maybe Kocherlakota is a New Keynesian. Maybe he thinks that speaking the language is a necessary compromise that buys influence on the Committee. In any case, the approach comes with some dangers. Primarily, if New Keynesian theory is not useful for understanding our current predicament, which I don't think it is, then we are in for more trouble.

17 comments:

I think you're going a little easy on Kacherlakota. What a muddled mess this was compared to his other speeches.

A little more inflation gets us to 5.5% UE? What an extraordinarily shallow Phillips Curve. And if inflation accelerates without UE dropping, does he really think his FOMC colleagues will join him in enforcing a 2.25% ceiling? This is more than a little naive. Finally, after several speeches in which he lays out in detail the case for structural UE, K. finally decides its all just superseded by "recent studies"? Whose? Ed Lazear's?

The FOMC members' central tendency is for the natural rate to be somewhere between 5.2% and 6.0%, and it's nuts that Kocherlakota wants to keep monetary policy super easy until the u-rate has fallen to about 5.5%.

Suppose people think the Fed will tighten as soon as growth takes off, and kill off a recovery. If the Fed can convince people it won't do that, people will expect faster growth. If they expect faster growth, they should be more willing to spend and invest today.

Stephen, are you claiming (i) money is neutral even in the short run, or (ii) conventional policy might have real effects but forward guidance is useless because the public doesn't take FOMC statements seriously? I don't think either position is tenable. Let me address your questions.1. Business as usual for the Fed is to raise rates once recovery sets in post recession. That is why the public might expect that sort of policy this time around. 2. The Fed can change those expectations by announcing that it plans to delay tightening this time. This announcement should have some credibility, because FOMC members will look foolish if they do not follow through on an announced policy - and presumably they do not want to look foolish. 3. I agree that we should take seriously the long-term consequences of this short-term convincing. 4. People will expect faster growth because they accept the conventional wisdom is that lower real rates are stimulative in the short run.

QE3 -- since it hasn't been tried, one cannot use data to determine what effects it might have. Thus, people's opinions about its effects are based on models, and models may not be particularly discriminating along this dimension. Try improving your education before speaking again, or you'll be given a spot in the Four Horsemen of the Crackpocalypse with Serlin, John D/Alexander Hamilton, and Greg Ransom.

Anon, if you’re lucky, you’ll wake up someday and ask yourself, “Why can’t I just make my case and let it speak for itself?” “What is it about my life that forces me to turn everything into a personal battle?” I hope you find the answer because you’ll be much happier if you.